27 June 1986 Income Tax Severed Letter 5-1411 - [860627]

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Dear Sirs:

This is in reply to your letter of April 11, 1986 in which you requested our opinion on the application of subsections 93(1) and 93(1.1) of the Income Tax Act (the "Act") in the following hypothetical situation (as illustrated in Appendix A):

• 1. Canco is a Canadian resident company which owns 100% of the shares of FA1, a controlled foreign affiliate.
• 2. FA1 in turn owns 100% of the shares of FA2, another controlled foreign affiliate.
• 3. FA2 in turn owns 100% of the shares of FA3, a third controlled foreign affiliate.
• 4. All corporations were incorporated after 1975.
• 5. The taxable and exempt surplus accounts of FA1, FA2, and FA3 as at the relevant time are:

Taxable Surplus     Exempt Surplus
          FA1                 $Nil                $Nil
          FA2                 $Nil                $ 30
          FA3                 $Nil                $100

• 6. The adjusted cost base of FA1's share investment in FA2 is $10. the adjusted cost base of FA2's share investment in FA3 is $50.
• 7. The fair market value of the shares of FA3 is $120.
• 8. The shares of FA1, FA2 and FA3 all constitute "excluded property" as defined in paragraph 95(1)(a.1) of the Act.

FA2 pays as a dividend-in-kind of its entire shareholding in FA3 to FA1, so that immediately after the dividend FA1 owns 100% of the shares of each FA2 and FA3 which are then sister subsidiary corporations of FA1.

Upon the dividend-in-kind being paid by FA2, subsections 52(2) and 93(1.1) of the Act and subsection 5902(6) of the Income Tax Regulations (the "Regulation will apply to recharacterize the gain on disposition of $70 ($120 - $50) as a dividend out of FA3's exempt surplus, so that FA3's exempt surplus is reduced to $30 and FA2's exempt surplus is increased to $100. The $120 dividend-the-kind payment to FA1 will come out of FA2's exempt surplus to the extent of $100 and out of pre-acquisition surplus to the extent of $20. As the adjusted coste has of FA1's share investment in FA2 is $10, a $10 capital gain will be realized by FA1. Pursuant to paragraphs 5907(1)(b), (f) and (i) of the Regulations, one-half of the gain, or $5, will be added to taxable earnings and the other one-half added to exempt earning. Thus, taxable surplus has been generated.

There is sufficient exempt surplus in FA2 and FA3 in aggregate ($130) to cover the full amount of the dividend ($120). The generation of taxable surplus could be avoided by the payment of a dividend by FA3 to FA2 in the amount of $20. However, in the situation described above where the payment of such a dividend is either not feasible or not desirable we concur with your opinion that this problem can be resolved by having Canco elect, pursuant to subsection 93(1) of the Act, that a further $20 of proce-eds, in addition to the $70 automatically elected pursuant to subsection 93(1.1) of the Act, be elected to be characterized as a dividend, rather that as proceeds of disposition.